Richard Green is a professor in the Sol Price School of Public Policy and the Marshall School of Business at the University of Southern California.
This blog will feature commentary on the current state of housing, commercial real estate, mortgage finance, and urban development around the world. It may also at times have ruminations about graduate business education.

All this is a natural result of the depreciation of the dollar. My question, though, is whether to be surprised by the fast improvement in net exports. I thought that when the currency depreciated as rapidly as the dollar has, the terms of trade effect in the short run is more important than how consumers adjust to changes in relative prices. That is, because foreign goods are more expensive, and because it takes awhile to substitute out of foreign goods, the net export position should actulaly worsen for awhile.

The large numbers of defaults in Inland California, Nevada, Arizona and Florida will cause pain for homeowners and endanger macroeconomic stability. That said, prices in these markets got well beyond fundamentals, and more corrosively, turned affordable housing markets into expensive markets (the USC group did some great work on how once inexpensive Riverside and San Bernardino Counties became havens for Southern Californians seeking homeownership.)

When prices in these places return to normal--and it is likely that they will--middle class household will again have large markets in which they can afford housing without strain. And that will be a good thing.

Friday, December 28, 2007

Krugman thinks a 50 percent fall along the coasts is possible. I am doubtful. The problem with using a PE ratio is the composition of the rental stock evolves differently from the compostion of the owner stock--the quality of owner occupied housing is generally improving more rapidly than the quality of the renter stock. For a working paper on this, see my piece with Cutts and Chang:

The Case-Shiller Index is declining in most cities (see http://blogs.wsj.com/economics/2007/12/26/home-prices-few-metro-areas-spared/).

So far as I know, this is unprecedented in the post-WWII era. In the past, even when a few housing markets have seen price declines, most have not. This means thar default risk and cost has been managable to investors in Mortgage Backed Securities.

The current environment is much tougher to deal with, and could mean that default costs arising from sub-prime mortgages will be higher than I expected earlier. It also cannot help but have a negative impact on house price expectations nearly everywhere. As I have said before, it is hard to see a turnaround coming anytime soon.

One bright side: when the commerical real estate market collapsed in the early 1990s, some analysts thought it would take a decade to recover--instead in took around 3-4 years to do so. Strong population growth in Arizona and Neveda should put some cushion underneath those markets (although the slowdown in Florida's population growth will further weaken a market that is already pretty devastated).

A month ago, they [the ports of Long Beach and San Pedro] approved a joint mandate to replace the area's fleet of 16,800 dirty cargo trucks with new or retrofitted models by 2012. Last week, the two ports approved a cargo fee to raise $1.6 billion to put the cleaner trucks into service.

and

The stakes are indeed high. The clean trucks program could yield a cumulative economic benefit of $5.9 billion from reductions in premature deaths, lost work time and medical problems, according to the Southern California Air Quality Management District.

If these numbers are remotely correct, then the policy of requiring the clean trucks is a no-brainer. Yet there is still a question about whether it will in fact get done, for reasons given in the remainder of the story.

The Coasian solution is to just assign property rights and step aside. If the people living near the port have the property rights, they can insist that the trucks get cleaner, and if the port is still profitable in the aftermath of incurring the costs, the port will continune to operate with lower levels of pollution (otherwise it will shut down, but this is highly unlikely); if truckers have the rights, the neighbors should find it worthwhile to pay for the trucks to get cleaner. The problem, though, is a coordination problem--it is difficult to get everyone to cooporate to get to the best economic outcome. This is why sometimes regulations really are the only practical method for getting something close to an economically efficient outcome.

To some extent, this sounds like a liquidity trap story: regardless of interest rates, people won't invest because they don't trust anything or anyone. The stubbornly high spreads on LIBOR and prime jumbo mortgages suggest that there is something to this. It also explains why people such as Larry Summers think a fiscal stimulous is necessary.

But even with a fiscal stimulous, it is hard to see how housing will not be a drag for awhile. Inventories are high, meaning house prices will have to come down in some markets to restore equilibrium. This will put pressure on mortgage performance, which will make lenders even more wary. Ironically, once prices fall to equilibrium levels, mortgages going forward will again be very safe loans. But evidence from Jeremy Stein in one paper and David Genesove and Chris Mayer in another implies house prices are sticky downward, so it may be awhile before we reach that equilibrium point.

WMATA is raising peak travel-time fares on Metro by 30 to 60 cents. From the transit agency's perspective, this makes sense--demand is highest at these times (sometimes to the point where the system is over-capacity), and so raising peak fares will encourage riders to travel at off-peak times.

On the other hand, any policy that discourages metro ridership at peak periods encourages automobile use at times when DC area roads are already jammed. If there were a London or Singapore type arrangement, under which drivers would have to pay a fee to drive into the city, an increase in metro fares could be accompanied by an increase in the cost of driving, so that travelers who were flexible would be encouraged to avoid both metro and the roads during peak periods. But DC has no such mechanism. It really needs one.

I keep reading stories about food pantries being under particular pressure this year. The stories would be more helpful if they could explain explicitly why the food stamp program (perhaps the most successful anti-poverty program in the US) isn't sufficient to prevent this. We do know that not everyone eligible for food stamps uses them, but this has always been true, and so wouldn't explain a change in demand at the pantries; we need to look elsewhere for an explanation.

My suspicion is that an accurate measure of CPI would vary by income group. The most obvious example is that low income people spend a higher fraction of income on heat, electricity and transportation than higher income people. Even if the entire CPI is flat, if the energy and transportation sectors see large rises in prices, it will likely have a particularly large impact on the bottom quintile of the income distribution, and hence cause real incomes within this group to fall. Of course, gas and heating oil prices gave risen a lot over the past couple of years.

When I look at the BLS web site, I don't find anything about different market baskets for different income classes--I do wonder if there is something out there.

Saturday, December 22, 2007

Having dissed the city earlier today, I thought I should say a word or two in its favor. But before I do so, let me note that I am a Wisconsin homer--I grew up there, got my Ph.D. there, and taught on the faculty at Madison for a long time.

The thing that prompted me to note Green Bay's core strength is this piece by Dick Meyer that appeared in this morning's Post.

The piece is here: http://www.washingtonpost.com/wp-dyn/content/article/2007/12/21/AR2007122101886.html?hpid=opinionsbox1

It begins with:

I went to my last professional football game this month. My son and I braved frigid, remote FedEx Field to see our beloved Chicago Bears, the fallen Super Bowl champions, humiliated 24-16 by the struggling Washington Redskins. It wasn't the depth of our despair that will keep us away from football stadiums for good but the depravity of the fans. I suppose depravity is a strong word. But what better describes drunken adult men, egged on by other grown beer-swillers, belly-shouting the most spectacular obscenities imaginable as they stand next to a 13-year-old boy? Every play was a competition to produce a more vile insult or a different suggestion about which Bear body part might be stuffed up which orifice.

As it happens, during my many years in Wisconsin, I was only able to obtain tickets to one Green Bay Packers game--a game against the Bears that took place in November 1989 (I remember the year because my wife was pregnant with our two girls). The Bears were very good at that time, and had long been the Packer's arch-rival. Green Bay fans are fiercely loyal to their team, and yet, I saw none of the behavior Meyer described from his experience at FedEx field. People in the stands were unfailingly polite. I should mention that Wisconsin had a pretty strong drinking culture--when I was a kid growing up there, I thought the three leading beverages must be milk, beer and Old Fashioneds. Yet I don't recall any obnoxious, loudmouthed drunks at the game.

Which brings me to the principal point--people in Wisconsin, and so far as I can tell, throughout Wisconsin, are friendly, modest and polite. Minnesota is this way too (Garrison Keillor pretty much nails the culture). I kind of miss that.

The gist is that prime borrowers are more ruthless about default compared with the past. I am not so sure. The distribution of borrowers is very different from the past, because many households who previously would never gotten close to a mortgage were able to obtain one within the past five years.

The default rate on prime mortgages remains quite low. I am not sure that we have any evidence that prime borrower attitudes have changed. We will need to wait and see.

Rush Limbaugh symbolizes Talk Radio; DailyKos symbolizes the Blogosphere. One could tell a variety of stories (and many have) about why this is true.

But there is another relationship between media venue and ideology where it would be harder to tell a story. Daily newspapers seem more conservative that the alternative weeklies (the one exception, perhaps, is that in my old town of Madison, the weekly paper, Isthmus, was a little less knee-jerk than the afternoon daily, the Capital Times. On the other hand, it was well to the right of the daily that people actually read, the Wisconsin State Journal. Isthmus was also the best paper in town). Put from another perspective, I have never seen a widely read weekly with conservative inclinations. One could speculate why this is the case--for example, writers for the weeklies don't get paid much. But from what little I know about the newspaper business, outside of the most famous papers, reporters for dailies don't get paid much either.

I rarely use Internet Explorer (I'm a Foxfire guy), and so I have never changed the home page from the default MSN page. When I accidentally opened IE yesterday, I saw a teaser for a story about "best starter cities for young couples." The thrust of the story is that it if one is young, it is better to live in Baltimore than San Francisco, so that one can buy an inexpensive house and accumulate wealth.

The problem with that idea is that successful (more expensive) cities are often places where people accumulate human capital, which can also lead to riches (and life satisfaction). Successful cities allow labor specialization (specialists often learn higher wages than generalists), have sufficiently deep labor markets for both members of a married couple to get good job matches, allow the development of networks (Silicon Valley is Exhibit A; Wall Street is Exhibit B), and also provide a greater variety of consumer and service goods (Burmese Restaurants, for example).

For a really good take on the labor market issue, go here: http://ideas.repec.org/p/max/cprwps/57.html, although Rosenthal and Strange do not cast the issue in quite so positive a light as I.

Going bank to the MSN piece, the top five places it gives for young families are

Atlanta

Minneapolis/St. Paul

Des Moines, Iowa

Provo, Utah

Green Bay, Wis.

I can see Atlanta (although while housing is cheap there, the commute will kill you) and Minneapolis (the only downside being, of course, the cold). But Des Moines and Green Bay? They are pleasant enough small cities, and housing is cheap in both places. But for long-term labor market opportunity, it is hard to make a case for either.

Friday, December 21, 2007

Mortgages in South Korea generally have short terms--three to five years at most. As such, they resemble the bullet mortgage that predominated in the United States before the Great Depression.

One of the reasons for the short term is that the longest term Korean benchmark security is a five-year treasury note. When I ask Koreans why the longest term is so short, they tell me it is the same reason why the county does not get a AAA bond rating--investors are nervous about the folks just to the north. Now that the rhetoric out of Pyongyang and Washington seems to be cooling, it will be interesting to see whether this ultimately extends the yield curve in the South.

Both Brad Delong and the Wall Street Journal have written about neckties. The Delong post is here:

http://delong.typepad.com/sdj/2007/12/semiformal-ipho.html

And the Wall Street Journal Article is here:

http://online.wsj.com/article/SB119820646382444181.html

Personally, I love neckties. In general, men are allowed to wear four colors--black, gray, blue and brown--and black and gray aren't really colors, and I don't like brown. Ties allow men to wear something red, or yellow, or purple, or green, or even pink. For this reason alone I hope they never go away--Obama notwithstanding.

I did learn from the Journal, though, that when visiting Islamic countries, I should wear some kind of wool or cotton tie; the key is to avoid silk.

Thursday, December 20, 2007

I do real estate, so I like maps. Boundaries have some delicious anomalies. For instance, there is the notch of Massachusetts into Connecticut. Rhode Island and Connecticut don't align perfectly. Kentucky has an orphan on its West end. Florida's panhandle got cut off--it originally went all the way to the Mississippi. There is a notch in the Northeastern corner of New Mexico. And we won't even discuss Michigan.

How did this all happen? I know some answers (Michigan) but would welcome others. I would also be curious as to whether others have favorite anomalies. I have focussed on the US (for which there are many more), but I would welcome candidates from anywhere.

... for saying he has a hard time understanding economics. I actually find his honesty refreshing. It strikes me that he is not acting proud of his misunderstanding (which is at the heart of some blogger's criticism); he is rather owning up to a limitation.

I am not a McCain supporter, but I think his roster of economic advisers is very good. John Diamond, Anne Krueger, Kenneth Rogoff, Harvey Rosen, and John Taylor are all incredibly strong academic economists, and Mark Zandi is among the very best business economists out there (I have some issues with the way he models things for his forecast, but he really wound up nailing the housing market). If he takes advice from these people (but not from Kevin Hassett, especially on the stock market), the country will be well served.

Consumer groups are complaining that the proposed Federal Reserve rules for subprime mortgages do not contain assignee liability provisions. Under such provisions, securities holders who invest in predatory mortgages could be sued by borrowers who were treated improperly.

As I have said in other venues, my thinking on subprime has evolved considerably over the past nine months. But I continue to think assignee liability it a really, really bad idea. Securities holders already have the right incentives: predatory loans that blow up harm the investors, and so they want to avoid them. Investors are learning this very painfully right now.

At the same time, securities markets are having a difficult time pricing MBS right now--participants at the moment have little confidence that they understand embedded risk, even in securities that are very safe. Assignee liability would add another layer of uncertainty to markets, and could cause them to seize up even more. It is an example where a "cure" could be worse than the underlying disease.

The House passed a one-year patch for the Alternative Minimum Tax, but failed to fund it. I am not sure that the AMT is actually so bad. It both removes deductions (that tend to be distortionary), and as such broadens the tax base. At the same time, it lowers the marginal tax rate, which improves incentives. Because it doesn't kick in until a household has well above median income, it is progressive over some range of the income distribution.

Larry Summers is saying a temporary tax cut is necessary to stave off recession, but he is talking about something more broad-based than this--I am not sure how stimulative a tax cut for those earning more (usually a lot more) than $75K would be.

The story points out, correctly, the among the few to see the problem coming were Ned Gramlich and current FDIC Chair Sheila Bair. Their foresight was remarkable, and many of the ideas they had for avoiding the crisis--including closer scrutiny of lending practices--were sensible.

But one thing that bothers me is the idea that the way to prevent a future crisis is the imposition of an "ability-to-pay" standard. Consider the case of the 35 year old who had had a strong income and decides to drop out of the workforce for two years to get an MBA. She moves to Palo Alto to do so. Her income is close to zero for two years, but she wants to buy a condo instead of renting. Is this person really a default risk? Or consider the case of a family confronted with a large medical bill--they decide to take out a home equity loan that pushes up their payment to income ratio to 55 percent for a few years. Is this a worse outcome than having it see its credit record deteriorate because it can't pay its medical bills?

It is possible that these instances are sufficiently rare that putting in place an ability-to-pay standard would be welfare improving. But I would do at it a different way. If everyone involved in the lending chain has money to protect, they will have an incentive to avoid making loans that can't possibly perform. And that, in the end, is the point.

I am probably out of my depth here, but I have never been able to help but notice that successful Presidents (but for one) have been good writers. Jefferson wrote lyrically, and FDR wrote his own first drafts of important speeches, although he certainly got help from Sherwood Anderson, Samuel Rosenman and Harry Hopkins (for a look at how he went about composing the "Day of Infamy Speech," see http://www.archives.gov/publications/prologue/2001/winter/crafting-day-of-infamy-speech.html).

I don't care much for Ronald Reagan, but he was successful at accomplishing what he wanted to accomplish, and his letters reveal a graceful style. And of course, Lincoln was a towering literary figure. The only exception I can think of is my university's namesake, although he contributed a lot to the drafting of the Farewell Address (with help from his friends Madison and Hamilton).

As it happens, the guy (yes, it's a guy) I like best for this year knows how to put words on paper too. But the fact that I like him suggests that he is doomed. The first candidate I really went all out for was Mo Udall, another literate man who was famed for saying (among other things), "The voters have spoken. Bastards." I was 17 at the time, and I have done about as well at picking candidates ever since.

Sunday, December 16, 2007

Region: Some observers have suggested that regulators and others have put too much reliance on ratings agencies to determine the risk of mortgage-backed securities and that even financially sophisticated parties “didn’t really know what they were buying.” Is this evidence that credit markets are inefficient?

Fama: That story just doesn’t appeal to me. First of all, it’s well known that rating agencies tend to lag actual changes in credit worthiness. For example, stock prices predict changes in ratings better. The best models of credit quality are basically options pricing models that work off the stock price. So I’m very skeptical of these stories. The bond market is a simpler market than the stock market. Bonds are simpler to evaluate than stocks, because there’s downside risk, but you don’t have to worry much about the upside: They’re not going to pay you more than they promised. So bonds are much simpler to deal with. Now bond products have become more complicated because of the securitization of that market, but still not that big a deal.

I disagree on a couple of counts. First, the fact that investors are not sure what to make of AAA right now is one of the causes of our current problems. When I gave my talk at USC the other day, Larry Harris asked whether some of the AAA MBS was safe. The answer, of course, is that some of the AAA stuff is very safe. When an MBS gets the first 35 percent of promised cash flows from the underlying mortgages, it is, indeed, very safe, and yet it is trading at a substantial discount, because investors (and likely overseas investors in particular) do not know what to make of AAA right now.

Second, Mortgage Backed Securities are very tricky investments, because borrowers get control of two embedded options: a call option to prepay the mortgage when interest rates go down, and a put option to default on the mortgage when house prices fall. So far as I know, no one has yet to do a good job pricing these options acurately, because borrower behavior with respect to the puts and calls has been, shall we say, unstable.

I rented one for the past three days, and now I want one, but not because of the money they save on gas. A Corolla is a lot cheaper, and gets sufficiently good mileage that one cannot justify the price premium for a Prius on gas costs alone.

I want a Prius because they are a gas to drive (so to speak). They handle really well, are easy to see out of, and because of their transmission, are incredibly smooth. I think, though, that thanks to South Park, I would need a bumper sticker that says something like: no, I am not smug.

I have spent the past couple of days in Los Angeles, visiting USC. I know I am strange for saying this, but I think some of the freeway interchanges there are rather beautiful. The most spectacular is the intersection of the Harbor and 105 freeways (photo comes from http://www.my-photo-blog.com/2006/11). While it is a terrific photograph, it doesn't really do the thing justice. It is otherworldly when you drive through it.

My guess is that the project cost considerably more than necessary to perform its function. But the graceful curves and views add more to the urban landscape than a normal interchange would. I think many tend to sneer at LA Freeways, but they are actually admired in other parts of the World. A Chinese municipal official who was in an executive class of mine said that he really admired LA because of the design of its freeways. Genevieve Giuliano, who directs a transportation research center at USC, notes that LA would have plenty of Freeway capacity, if only the front passenger seat in cars were occupied more often. Indeed, a car with two occupants is a pretty efficient transportation technology under many circumstances (you can, after all, then multiply MPG per passenger by two). The tough question, as Professor Giuliano puts it, is how to fill that passenger seats. HOV lanes really haven't done it. It will probably take tolls.

Thursday, December 13, 2007

I am a big fan of Witold Rybczynski. He writes books (such as City Life and Home) that are insightful, whimsical, and blessedly short. Yesterday, he had a wonderful slideshow in Slate about the state of garage architecture:

http://www.slate.com/id/2179373/

It actually makes sense for parking garages to go upscale. In Washington, it costs around $200 per month to rent a space downtown. A typical parking space is about 170square feet. The costs of maintaining a garage are pretty minimal, so let's say that a parking garage owner nets $170 per month, or $1 per square foot per month, or $12 per year. At a cap rate of 8 percent, this means that parking spaces are worth $150 per square foot, or around $25,500 per space: this is not chump change for something that requires no interior walls, no heat, etc. [Update: of course this is value per space. Because garages have lots on non-leasible space, the value of the entire garage will be less]. Washington is not remotely the most expensive city for parking, either. New York (of course), Boston, San Francisco and Philadelphia (!!) are more expensive places to park.

Given the expense of parking spaces, one does begin to wonder why garages don't start charging by the square foot rather than by the space. Part of the garage could be configured for Honda Fits and Cooper Minis; another to Hummers and Escalades. I know this adds a layer of complexity, but all other types of real estate come in various configurations.

In my ideal world, Hummers and Excalades would pay higher tolls on East Coast Turnpikes too--they do, after all, take up more space, and therefore impose higher marginal costs of congested roads. I think people should be able to drive whatever they like, so long as they internalize the costs of doing so.

Wednesday, December 12, 2007

I am in Southern California for a few days, and when a Prius was available in the National Car Emerald Aisle, I took it. It is actually a lot of fun to drive--it makes no noise at stop lights, and is remarkably smooth on the freeway.

A limited number of Prius' get stickers that allow them into HOV lanes even if the driver has no passengers. A friend of mine pointed out that these stickers add substantial value in the secondary market. A story from last spring on NPR notes:

The California legislature approved 85,000 permits that will allow lone drivers of hybrid cars to drive in carpool lanes. The permits come along with big, yellow decals.

In February, the DMV mailed out the last of the 85,000 sets of stickers. Now the only way to get a new one is to buy a car that already has the stickers.

That difference is turning up in the cost of used cars, say the people at Kelley Blue Book. The re-sale analysts have figured out that a used Prius that already has the stickers is going for $4,000 more than one that lacks them.

There have been reports of stickers being stolen off cars — but the DMV doubts this is happening. The decals are tamper-proof. If you remove them they crumble and read "VOID."

Tuesday, December 11, 2007

Course Description: This is a course on fixed income real estate securities. It will explore the peculiarities of mortgages and mortgage-backed securities. While there is a suggested text with good background, I do not “teach the text.” I hand out notes and expect you to learn largely by doing.

We will value these securities and analyze their risk using tools from finance theory and real estate valuation theory. Most of the work will be performed in spreadsheets. We will do spreadsheet work in class—if you have a laptop, please bring it to class. Data for class will be posted on the class web site.

The Primary Residential Mortgage MarketAn Institutional Overview of Government Sponsored EnterprisesRichard K. Green and Susan M. Wachter, The US Mortgage in Historical and International Contexts, Journal of Economic Perspectives, Fall 2005.

The odds o(E) of an event E is the ratio of the probability that the event will occur, P(E), to the probability that it won't, 1-P(E), that is,

For example, if the probability of an event is 0.20, the odds are 0.20/0.80 = 0.25.

In epidemiology, odds are usually expressed as a single number, such as the 0.25 of the last paragraph. Outside of epidemiology, odds are often expressed as the ratio of two integers--2:8 (read "2 to 8") or 1:4. If the event is less likely to occur than not, it is common to hear the odds stated with the larger number first and the word "against" appended, as in "4 to 1 against".

When the odds of an event are expressed as X:Y, an individual should be willing to lose X if the event does not occur in order to win Y if it does. When the odds are 1:4, an individual should be willing to lose $1 if the event does not occur in order to win $4 if it does.

The Fascination With Odds

A common research question is whether two groups have the same probability of contracting a diseaase. One way to summarize the information is the relative risk--the ratio of the two probabilities. For example, in 1999, He and his colleagues reported in the New England Journal of Medicine that the realative risk of coronary heart disease for those exposed to second hand smoke is 1.25--those exposed to second hand smoke are 25% more likely to develop CHD.

As we've already seen, when sampling is performed with the totals of the disease categories fixed, we can't estimate the probability that either exposure category gets the disease. Yet, the medical literature is filled with reports of case-sontrol studies where the investigators do just that--examine a specified number of subjects with the diesease and a number without it. In the case of rare diseases this is about all you can do. Otherwise, thousands of individuals would have to be studied to find that one rare case. The reason for the popularity of the case control study is that, thanks to a little bit of algbera, odds ratios give us something almost as good as the relative risk. allow us to obtain something almost as good as a relative risk.

There are two odds ratios. The disease odds ratio (or risk odds ratio) is the ratio of (the odds of disease for those with some exposure) to (the odds of disease for those without the exposure). The exposure odds ratio is ratio of (the odds of exposure for those with disease) to (the odds of exposure for those without disease).

When sampling is performed with the totals of the disease categories fixed, we can always estimate the exposure odds ratio. Simple algebra shows that the exposure odds ratio is equal to the disease odds ratio! Therefore, sampling with the totals of the disease categories fixed allows us to determine whether two groups have different probabilities of having a disease.

1. We sample with disease category totals fixed. 2. We estimate the exposure odds ratio. 3. The exposure odds ratio is equal to the disease odds ratio. Therefore, if the exposure odds ratio is different from 1, the disease odds ratio is different from 1.

A bit more simple algebra shows that if the disease is rare (<5%), then the odds of contracting the disease is almost equal to the probability of contracting it. For example, for p=0.05, , which is not much different from 0.05. Therefore, when a disease is rare, the exposure odds ratio is equal to the disease odds ratio, which, in turn, is approximately equal to the relative risk!

Normally it falls to conservatives to cry “moral hazard” when policies such as this, expressly designed to reward imprudent behaviour, are announced. This time, the indispensable Barney Frank, the Democratic chairman of the House financial services committee, is leading the chorus. As he points out, the plan bizarrely confines its promised assistance to borrowers with poor credit histories. More than a third of mortgages currently in foreclosure were granted to prime borrowers; and, of those, more than half were adjustable-rate loans. Under the Paulson scheme, prime borrowers who get into trouble when their teaser rates reset will have to refinance, if they can; otherwise, they are on their own. Borrowers who struggled to improve their credit scores before taking out their mortgages are going to feel aggrieved. In many cases, the reward for those efforts will be eviction.

Betting markets usually are good at prediction, but this morning I read that the betting action has made the Patriots odds-on favorites to have a perfect season.

Two things make me skeptical--Tom Brady's touchdown-to-interception ratio, and the number of games left on the Patriot's schedule.

Tom Brady has a 9-1 touchdown to interception ratio this year. This is astonishing, and surely reflects luck. Over his career before this season, his ratio has been an excellent 2-1 (stat comes from TMQ). A ratio that improved to 3-1 or 4-1 could reflect fundamentals (better line play, better play calling, Randy Moss, etc), but 9-1 must reflect a lucky draw.

If Brady returns to normal, it would be reasonable to expect New England's probability of winning to drop to .9 against most teams, and .6 against the Colts at home. They have five games remaining before they (presumably) play the Colts for the Super Bowl. So the chance of the Colts winning the last 6 is .9^5*.6, or .354.

This is still a ridiculously high probability for going undefeated, but it makes it a 2-1 fair bet, rather than less than 1-1.

The NAR Existing Home Sales report came out yesterday, with one not-terrible number (pending sales seem to have flattened) and one bad one (the months of inventory available for sale continues to rise).

The official line of NAR is that New Home Sales will fall next year, while Existing Home Sales will turn around. I am doubtful on both the relative and absolute picture for existing home sales. Builders, who are usually high leveraged, need to get rid of houses, and are willing to slash prices to do so. As Genesove and Mayer showed in a terrific paper on nominal loss aversion, homeowners seem to have a strong distaste for selling at a loss. Second, while NAR asserts that the mortgage market is improving, I don't really see it. Spreads on jumbos had narrowed some, but the subprime market seems to be gone for the time being. The fact that inventories continue to rise relative to sales also makes it hard to foresee a turnaround. And in certain regions of the country (the inland empire of California), foreclosures will make things even worse.

If I were NAR, I would be advising their members to advise their sellers to expect to take a price cut; until that happens, inventory will continue to be a drag on the market. Then again, turning points are tough to call, and I could be all wet. But I don't think so.

Monday, December 10, 2007

Deepak Bhattasali from the World Bank gave a nice talk here at GW tonight to officials from Wuhan and Shaoxing. Some takeaways I got:

(1) The unevenness of China's income distribution is approaching the US. Part of the reason for this is that internal migration is still stunted by government policy. The lack of labor mobility means that skilled labor that happens to already be in manufacturing cities commands a premium.

(2) With five levels of government, China may overdo federalism just a bit.

(3) Banks have to learn modern underwriting techniques. The ratio of GDP growth to investment in China is much lower than it is in India. In light of how poor India's infrastructure is, and how good China's is, this is remarkable. (My own view--China needs private sector banks).

(4) China has cut its poverty by 3/4 in less than 20 years. This is breathtaking.

Reply to a criticism during the Great Depression of having changed his position on monetary policy, as quoted in Lost Prophets: An Insider's History of the Modern Eonomists (1994) by Alfred L. Malabre, p. 220

And just as germane at the moment:

"If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has."

Sunday, December 09, 2007

Testimony of Richard K. GreenOliver T. Carr, Jr. Chair in Real Estate and Finance, The George Washington UniversityBefore the House of Representatives Committee on Financial ServicesDecember 6, 2007

Chairman Frank, Representative Bachus, and members of the committee, thank you for inviting me to testify today as part of this hearing on “Accelerating Loan Modifications, Improving Foreclosure Prevention and Enhancing Enforcement.” My name is Richard K. Green, and I am the Oliver T. Carr, Jr. Chair in Real Estate and Finance at the George Washington University. Before teaching at George Washington, I taught at the University of Wisconsin-Madison and the Wharton School of the University of Pennsylvania. In the interest of disclosure, let me note that I worked for Freddie Mac for about 16 months in 2002-03, and that I own a small amount of Freddie Mac stock (whose value is considerably lower than it was six months ago!) Let me begin by saying that my thoughts on the subprime crisis have evolved considerably over the past year. Last March, I was quoted in Newsweek as saying that I thought the damage arising from the subprime mess would be limited. I was clearly wrong. And so as events have changed, my thoughts on appropriate policy responses to the crisis have changed as well.Mass loan modification is one example of how my views have changed. Not so long ago, I worried about the moral hazard problems that could result from effectively allowing a large class of borrowers to change the rules of a loan after it was originated. When initial loan terms are not enforced, future investors will be less willing to invest in mortgages, which in turn can reduce the availability of mortgage credit. But this point seems moot at the moment.Three things have led me to change my mind about modification. First, and most important, is the fact that it will be difficult to preserve macroeconomic stability if we ignore the fact that already dangerous loans will become even more so when their payments increase, sometimes dramatically. For reasons I will describe later in my testimony, I do not think that modification is by any means a panacea. But past experiences in the history of the US mortgage market give us reason to believe that mass modification can be an effective tool for restoring stability to financial markets.Before the Great Depression, the typical mortgage in the United States had some features in common with many current subprime mortgages: floating interest rates, no amortization, and the possibility of “payment shock. ” The payment shock arose from the fact that mortgages had balloon payments: borrowers were forced to refinance regularly. If they could not refinance, they owed a balance roughly equal to half the purchase price of the house.

This housing finance system worked reasonably well until the Great Depression, when bank illiquidity made lenders call loans when they were due. Households rarely had enough cash to pay off their mortgages and so needed to sell their homes to meet their obligations. The lack of liquidity meant that buyers could not obtain financing, so sellers could not sell. This led to waves of foreclosures, followed by real estate owned by financial institutions, which in turn created more illiquidity; and soaring default rates. The market clearly needed a “servicing” solution.

In response, the Hoover Administration created the Federal Home Loan Bank System, and New Deal housing finance legislation created the FHA to insure long-term mortgages and the Home Owners Loan Corporation (HOLC) and its successor, the Federal National Mortgage Association, to tie mortgage markets to capital markets. HOLC, backed by the full faith and credit of the U.S. government, raised money in the bond market to purchase non-performing mortgages from depository institutions. HOLC reinstated the loans as 20-year fixed-payment mortgages (Green and Wachter 2005). This can be seen as the first example of mass loan modification. Borrowers were removed from an impossible position (where they had to raise a large amount of cash to pay off a mortgage balance) and placed in a manageable position. At the same time, by changing the terms, the federal government reduced the embedded risk of the loans and therefore increased their value to depositories, which ultimately bought them back from HOLC.

Second, I have come to appreciate that transactions between borrowers and lenders are hardly typical. Even the simplest fixed-rate mortgage, whose cost is a function of rate, term, points, fees, and expected time in the home, is not a straightforward product. Adjustable rate mortgages are more complicated than fixed-rate mortgages; exotic ARMS are even more so. At a conference sponsored by the Joint Center for Housing Studies last week, professors of law and economics from leading universities could not explain in detail all the characteristics of their adjustable rate mortgages. To expect consumers with far less financial acumen to understand the terms of exotic ARMS is unreasonable. It is particularly noteworthy that as we gather more evidence about the characteristics of subprime borrowers, we find that increasing numbers of subprime loans were going to borrowers with relatively high FICO scores. I have become increasingly convinced that large numbers of borrowers were pursuaded to take on products that they did not understand (I also leave open the possibility that some of the brokers who sold the loans did not really understand them either). Third, structured finance has made loan modification on an individual loan level difficult. The interests of the different investors in various classes of securities can be in conflict: when a loan is in default, it is possible that investors holding a senior tranch will prefer foreclosure to workout, while those holding junior tranches might prefer workouts. At the end of the day, this conflict could prevent workouts in cases where both borrowers and the sum total of investors would be better off with a workout, indicating that workouts are economically efficient, at least in the short run. But let me raise a flag about problems that might arise: trusts that hold mortgages are supposed to be passive entities. Large numbers of workouts could turn them into active entities, which in turn could, under the terms of the trust, lead to dissolution. The legal implications of all this are well beyond my ken (I am not a lawyer), but they need to be considered as Congress moves forward with legislation such as HR 4178.In my opinion, as we think about solving the current crisis and developing reforms for the mortgage market of the future, we must keep in mind how important it is to develop incentives that will allow us to get out of our current predicament and prevent future crises. To me, a combination of incentives and improved information will be more effective than detailed regulation (big picture regulation is another matter, and something I will get to in a minute).For the time being, the key loan modifications would be: (1) to freeze ARM payments for particular types of ARMS and (2) to allow ARM borrowers whose mortgages have prepayment penalties to refinance without having to pay these penalties. But in determining the level at which to freeze ARM payments, we should not freeze rates below A and alt A rates, both for equity reasons and because we want to encourage borrowers who can refinance into A or alt A products do to so. We also should be sure only to modify loans for borrowers who occupy the house under mortgage.As we look forward, new regulation should focus on aligning incentives to mitigate against the adverse selection and moral hazard issues that led to the current crisis. To be more specific, changes in policy should accomplish three things:(1) It should make sure that all parties in the lending chain have “skin in the game.” While reputational risk mitigates against bad behavior, there is not a substitute for financial incentives.(2) It should make sure that all parties in the lending chain are subject to federal supervision. This will reduce regulatory arbitrage.(3) It should do what it can to improve disclosures throughout the lending chain. Borrowers must be better informed as to the consequences of their lending choices (although this will be difficult); bond ratings must be consistent, and securities must be more transparent.

All this said, it is important to recognize that no amount of modification can produce a panacea to the current crisis. First of all, we know that many defaults occurred before a rate reset, and so they were induced by something other than payment shock. It is actually an interesting and open question as to whether those borrowers with the greatest propensity to default have already done so. In the distant past (i.e., the 1970s and 1980s), default usually occurred in the third to seventh year of a loan’s life. We now have the unusual spectacle of books of mortgages that contain large numbers of loans that didn’t receive a single payment. This means history gives us little guidance about how these mortgages will perform going forward.Second, the current outlook for the housing market is grim. Economic theory tells us that one of the key determinants of current house prices is expectations of future house prices. A very small change in expectations can actually lead to a very large change in house prices. One of the best ways to look at expectations for house prices is to look at the S&P/Case-Shiller futures market for houses ; in this market, people actually place money behind their opinions about future house price movement. And right now the market is telling us that people’s expectations are not positive. This by itself could push down house prices for awhile, which will eat away at home equity, which will make mortgages more vulnerable. Reducing the possibility of payment shocks and making loans easier to refinance will help, but for a person who loses his job, gets sick, or sees his marriage dissolve, the fact that his mortgage balance is higher than his house value may leave him with little alternative but to default. Reducing impediments to modification will, however, reduce the probability of foreclosure somewhat, and will therefore reduce the inventory of homes available for sale going forward. This can do nothing but help expectations about future house prices, and therefore make the market less bad than it would otherwise be. I think for the time being, reducing the damage from the subprime crisis is the best we can expect to do.

Wednesday, December 05, 2007

After I do my testimony (written at last!), I am getting on an airplane to Boston, where I will be attending a conference in honor of Chip Case. Along with being a great Wellesley teacher, a terrific housing scholar, and a rare academic entrepreneur, Chip is responsible for generations of economics students at Harvard: he designed the iconic course know as Ec 10. Ec 10 was what turned me into an economist, and for that I am entirely grateful.

I am discussing a paper from John Quigley and Berkeley colleagues on land use regulation and house prices in San Francisco. I will post those comments here after I discuss them in person. John continues to amaze me with the depth of his work--he pulls together very difficult data and then analyzes them using the most rigorous tools going. Although John has never been my teacher per se,and even though I have had great mentors in my career--Kerry Vandell, Pat Hendershott, Buz Brock to some extent and of course Robert Baldwin--I don't know that I have ever learned as much from one man as I have from John Q.

John and Ed Glaeser are the hosts for the conference, which will fill with luminaries with which I don't hold a candle. But I'll have lots of fun anyway.

I am trying Brahms with the hope that he helps. Anyway, I in my office have this relative cheap stereo (NAD L-40 with a pair of PSB mini speakers) that sounds amazing to me. I think I bought it seven or eight years ago. Talk about bargains...

I remember when I first heard about CDOs, I didn't understand them--or maybe I should say I did. They were explained to me as being tranched securities of tranched securities: that is, they took subordinated debt pieces, wrapped them together, and then tranched them again, so there were senior pieces of subordinated tranches.

But these really weren't senior pieces--they were "mezzanine " pieces--pieces that got paid after the original senior piece got paid, but before the sub of the sub got paid. In any event, it was pretty risk stuff, and it is now taking a beating.

Nevertheless, just because people invested stupidly in innovative securities, innovations in securities are not per se bad things, and on net (in my view) contribute benefits. The development of the mortgage backed security market in the 1970s was an important and welfare enhancing innovation that brought liquidity to the mortgage market everywhere in the United States, and perhaps preserved the 30-year fixed rate mortgage as an instrument for American consumers. Even now, the conventional conforming mortgage market continues to cook along just fine.

Perhaps the most important thing the Fannie/Freddie MBS market did was bring standardization to mortgages, so that they could be underwritten, packaged and sold as commodities. The mortgages creating the problems we are facing now are anything but standard.

Sunday, December 02, 2007

Some questions for William Poole, president of the FRB St. Louis. The answers are extracted from his speech Market Bailouts and the "Fed Put":

One of the arguments against the Fed taking action to reduce problems in financial markets is that this creates a moral hazard problem. Can you remind us what the concern is?

The concern over moral hazard is that monetary policy action to alleviate financial distress may complicate policy in the future, by encouraging risky investing in the securities markets.

Do we know much about financial turmoil of the type we are experiencing now?

There are so few instances of market turmoil similar to the current situation that I’ll broaden the analysis to include significant stock market declines. Doing so gives us a substantial sample to discuss.

The U.S. stock market, between its peak in 1929 and its trough in 1932, declined by 85 percent. Question 1: If the Fed had followed a more expansionary policy in 1930-32, sufficient to avoid the Great Depression, would the stock market have declined so much? Question 2: Assuming that a more expansionary monetary policy would have supported the stock market to some degree in 1930-32, would it be accurate to say that the Fed had “bailed out” equity investors and created moral hazard by doing so? I note that a more expansionary monetary policy in 1930-32 would, presumably, have supported not only the stock market but also the bond and mortgage markets and the banking system, by reducing the number of defaults created by business and household bankruptcies in subsequent years.

Now apply these questions to the current situation. Did the Fed “bail out” the markets with its policy adjustments starting in August of this year? Have we observed an example of what some observers have come to call the “Fed put,” typically named after the chairman in office, such as the “Greenspan put” or the “Bernanke put”? Why has no one, at least not recently to my knowledge, argued that a more expansionary Fed policy in 1930-32 would have “bailed out” the stock market at that time and, by implication, have been unwise?[1]

Some people aren't going to make it to the end of this discussion. Any chance you could give a summary of the bottom line?

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

William Poole is a monetarist (he wrote a book called Money and the Economy: A Monetarist View, so I think I am characterizing him fairly), so these comments are quite significant. As I noted in my impressions of the conference on Understanding Consumer Credit at Harvard last week, we may have reached the point where the mortgage crisis is sufficiently contagious that actions to fight it (such as freezing the interest rates on ARMS) should not create serious moral hazard problems, or in any event, the moral hazard problems pale in comparison with the problems that would arise from passivity.

Maybe I don’t have what it takes to be a serious columnist. I mean, it would never have occurred to me to suggest that the only way to explain an economic forecast I don’t agree with is to say that it must be part of an evil plot to drive down the market, so that Goldman Sachs can make money off its short position — and to suggest that Goldman should be the subject of a federal investigation.

But he goes on to say

For what it’s worth, Goldman’s forecast of a 15 percent decline in home prices seems implausible to me, too — but on the low side. A 15 percent decline would bring prices back to their level in early 2005 — when the bubble was already well inflated. If prices fall back to their level in early 2003, that’s a 30 percent decline.

Implicit here is the assumption that prices in 2003 were roughly in equilibrium, and I think that is probably right. But if prices rose by 3 percent per year since then (that is, if real prices stayed constant), then prices would only need to fall around 21 percent to get us back to alignment with fundamentals.

OK--that is really, really picky, and truth be told, I have no idea how much prices will fall (or even if they will continue to fall) for reasons I have explained in other posts. It's just that Krugman is usually precisely correct, so I am surprised he benchmarked to a nominal, rather than real, price from the past.

Today, twice as many Wisconsin-Madison professors are leaving to work elsewhere as was the case five years ago. Huge piles of cash aren't always the issue; sometimes it's the bureaucratic or political constraints more common on public campuses. Among the faculty that Farrell particularly regretted losing was Robert W. Carpick, a fast-rising associate professor specializing in nanotribology (the study of friction at the atomic level) who defected to the University of Pennsylvania a year ago. Carpick, who took much of his $550,000 in outside research grants with him to Penn, accepted a salary only 10% higher than the $90,000 he was making. The main reason he left Wisconsin is that it is prohibited by state law from paying domestic partner benefits, Carpick says. "I also was concerned about the effects of dwindling state support on the public university model."

I go to lots of meetings where people claim that baby boomers are returning to central cities. Here are some data on population growth change of the 25 largest cities and the US between 2000-2006.

Detroit city -8.43%Philadelphia -4.56%San Francisco -4.21%Milwaukee city -3.96%Baltimore city -3.04%Chicago city -2.16%Boston city 0.28%Indianapolis 0.48%Washington city 1.66%New York city 2.57%San Diego city 2.74%Columbus city 3.05%Memphis city 3.20%Seattle city 3.39%Dallas city 3.73%San Jose city 3.91%Los Angeles 4.18%United States 6.30%Jacksonville 8.01%El Paso city 8.12%Austin city 8.12%Houston city 9.77%San Antonio 13.28%Phoenix city 14.53%Charlotte city 16.58%Fort Worth city 22.19%

The data are estimates that come from the census web site. First note that all but eight cities have grown less rapidly than the country as a whole; this means that their population growth comes from births over deaths, rather than net in-migration from, say, the suburbs. Moreover, in New York, San Diego, Los Angeles and San Jose (perhaps others as well), much of the in-migration comes from abroad, meaning that domestic out-migration is larger than the raw figures would suggest. Finally, those cities that grew faster than the country--Jacksonville, El Paso, Austin, Houston, San Antonio Phoenix, Charlotte and Fort Worth--either have strong annexation powers or lots of land at the urban fringe inside of municipal boundaries. They do not reflect population moving from the fringe into the center city.

Some cities are doing well despite the absence of much population growth. And here in Washington, the population of white affluent people is growing, but it is pushing out low-income African-Americans, largely to Prince George's County (a suburban county to the northeast). The affluent moving in are more likely to be childless (according to Julia Friedman, only five percent of taxpayers in the District are married couples with children), and so they are driving down density per housing unit. This is why population is not growing much, but the fiscal condition of the city has improved dramatically.

Understanding both the modest Midwest tradition and the school pride of its alums, Mike Knetter organized a collective $85 million naming gift that will preserve the name Wisconsin School of Business for at least 20 years.

There are universities that instill a fervent love among their students and faculty, and Wisconsin is among them. I always thought the motto of the place should be "excellence without stuffiness."

Saturday, December 01, 2007

James Hamilton's analysis of the surprisingly strong 3rd quarter GDP number is here:

http://www.econbrowser.com/archives/2007/11/new_gdp_figures.html

Jim's description is, as usual, clear and insightful. One striking point: while residential construction declines subtracted about one percentage point from GDP, around 40 percent of that was offset by exports from just one sector, civilian aircraft and engines. Because Boeing is the only civilian commercial (as opposed to private) aircraft company remaining in the United States, this means it has taken on a remarkable share of the burden of keeping the country out of recession.

So here is a fanciful question: how much do consumer preferences about aircraft shape airline decisions about what they purchase? The nicest airplane I have ever flown on is the Airbus 340-500 (it is the one that can fly from Newark to Singapore), and I would much rather fly on an Airbus 319-320 than a Boeing 737. Pilots have also told me that Airbuses can land in conditions of extremely low visibility (perhaps Boeings can as well, I don't know).

I am guessing that passenger comfort pales in comparison to operating and acquisition costs, and Boeing may have the edge there (I know the 787 is supposed to be very economical). Perhaps I am also unusual in my preference for Airbuses...